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Tough Questions for Dr Bernanke and Other Macroeconomics Leaders

Following on from my previous post on the trouble in mainstream macroeconomics, I was very interested to hear what five of the world’s very top economists had to say for themselves at Monday’s event at the LSE to honour outgoing Bank of England governor Sir Mervyn King. The event included talks by Ben Bernanke (Chairman of the Federal Reserve), Olivier Blanchard (Chief Economist at the IMF), Larry Summers (former US Treasury Secretary), and Axel Weber (ex-head of the Deutsche Bundesbank, now Chairman of UBS). Mark Carney, current governor of the Bank of Canada and the next governor of the Bank of England, was in the audience. The event was entitled “What should economists and policymakers learn from the financial crisis?”, and it came with the teaser:

“Five years on, the global economy continues to come to terms with the impact of the financial crisis. This event examines the lessons that both economists and policymakers should learn in order to lessen the chance of future crises.”

Bernanke’s talk (reported on with full transcript here) was interesting, but mostly just a fine demonstration of how to give a polite, but aggressive, political speech. He argued that accommodative monetary policies in the advanced economies support aggregate demand, and offset any effects of currency appreciation on the emerging market economies (i.e. China).

Oliver Blanchard spoke about how the crisis had demonstrated that the financial system matters. That is, the way he had thought about how the system works was that the central bank would set the discount rate, and then the people on Wall St would work out all other rates everywhere (basically acting as a human computer to solve a set of arbitrage equations). However, economists have now learnt that they need to be more micro-focused, and that “the plumbing matters”.

The remarks made by Larry Summers and Axel Weber were particularly interesting. This is likely because in their now private positions they feel more comfortable saying things they would never have been able to while in public office. Weber’s most interesting remarks were on specific issues relating to international bank regulation and management and so they are perhaps not interesting to a general audience.

But Summers called for a substantial reconstruction of macroeconomics and central banking practice, which is something that may affect us all. He noted that the premise of virtually everything he studied in grad school, and that he taught for some years, was that coherent models move quickly from equilibrium to equilibrium as conditions change. But this has been called into question by the last few years. If there had been no lending of last resort, and the accompanying expansionary monetary and fiscal policies, then it is not clear what equilibrium if any would have been achieved (“an unbounded downward spiral” being a likely outcome in Summers’ opinion).

Summers then pointed out how almost every treatment of macroeconomic fluctuations over the past 30 years has assumed that economic output fluctuates around a trend. And that if one managed policy badly, there would be more volatility around this trend (whereas there would be less volatility if policy was managed well), but that the average level of output would not be affected by stabilization policy. This led many to believe that stabilization policy was a second order question.

However, in Summers’ words “the events of the last few years surely demonstrate that an older view, that macroeconomics was about avoiding the waste associated with recessions, is the more important view”. In his opinion there is no question that if more enlightened economic policies had been in place that resulted in the avoidance of the past 6 years of recession and high unemployment, then this would not have resulted in growth during some future boom time being lower just so that some long-run average of output is maintained. That is, recessions are wasteful and if they can be avoided the long-run level of output can be improved. Thus, according to this view, a model of periodic malfunction is necessary, which is quite different from one which presumes a constant mean. To conclude this thought, Summers stated that “this will be a very different macroeconomics to the macroeconomics that I studied, or the macroeconomics that has been taught in the past”.

After each of the speakers had given their talk, Meryn King opened up the Q&A with a question of his own, highlighting the idea that Summers had brought up: “How would you reconstruct macroeconomics?” Bernanke’s answer, in agreement with points made earlier by Blanchard, was that you need to bring financial markets into the equation more. He pointed out that while perhaps even more (financial) wealth was destroyed when the tech bubble popped than when the housing bubble burst, the bursting of the housing bubble has been much more damaging because the financial markets were far more vulnerable to declines in house prices.

In his answer, Weber delivered the amusing anecdote that while he was head of the Bundesbank he compared the lists of the top 20 purchasers and sellers of securitized products and they were the same institutions! So much for risk sharing and diversification! To him this was a result of too much of a micro focus (i.e. the idea that ‘if we package our mortgages together, chop them up, and sell them off it will be good for our individual bank’), and not enough of a macro, systemic focus. Interestingly this contrasts with what Blanchard said about macroeconomic models needing to include more micro knowledge. It seems that the bankers were too micro-focused, while the policy makers were too macro-focused.

Summers posed another question as part of his answer to the question of how to reconstruct macro. He asked whether macroeconomics should be about reducing the amplitudes of cyclical fluctuations around average output? Or is it about avoiding catastrophic downturns with millions of people unemployed for millions of person years, at the cost of trillions of dollars, which are avoidable with more satisfactory economic arrangements? He then emphasized how important this change in perspective is:

“Unless or until we adopt the second vision, I think we are missing what is our principle opportunity to achieve human betterment. And as long as the question is conceptualized as ‘What new friction should we insert into the existing model? And then we’ll have it.’, I don’t think we’re going to get to the kind of perspective that I’m advocating.”

He then further emphasized his point, while pointing out quite humbly (a least for someone who’s known as an arrogant economist) that talk is cheap:

“Now it’s easy to say this, it’s much harder to provide a constructive vision, but there are a number of schools of work that to date I think have been sufficiently abstract that they have not made easy connection with practical policy problems that involve multiple equilibria, or that involve fragile equilibria, that have the prospect of capturing the kind of notion that there are these periods where you have a very bad outcome that you somehow could avoid without compromising the future in a very serious way. Because it is true that a little bit of avoiding what’s happened for the last six years is worth a lot of making the amplitude of the fluctuations smaller.”

The event closed with an excellent question from the audience, asking these top policy makers to really think about what the purpose of their jobs is: “What do you think is the purpose of economic growth and prosperity?”. First, Weber noted that it is a concern of his that future generations have no representation at the table where policy decisions are made. So his concern is that the excessively loose monetary and fiscal policies that are being used to try to reignite growth now are unsustainable, and they may turn out to be detrimental to future generations. Summers then argued the opposite. While he does share Weber’s concerns, he argued that on behalf of his children he is more concerned that excessive austerity in the short-term would stunt the ability of their generation to develop, educate themselves, and find fulfilling jobs.

Blanchard answer the question in the following way “I’m not a growth freak, in the sense that maximizing the growth rate doesn’t strike me as a desirable objective. And the work on happiness… strikes me as extremely relevant.” Then Bernanke finished with a economist’s joke: “Suppose you have a choice between [just leaving things as they are or] the same level of GDP in the UK as we have today, but higher employment, which would you take? And economists would tell you, ‘Well the lower employment of course, because all this leisure is valuable!’. That just shows you how economists think!”. He then explained that at the Federal Reserve they don’t just focus on GDP growth, they also look at unemployment numbers. And that this is just one way that economists acknowledge that the problem of capturing all that matters to people in an economy is a complex challenge.

In summary, it was good to see that at the very highest and most public levels of the economics profession there is an awareness of the need to reconstruct macroeconomics. As well as an awareness of complexity of what constitutes human well-being, and the interesting results that microeconomic researchers are finding on human happiness. However, as Summers said “it’s easy to say these things”, so it remains to be seen how economics will change in the years to come.

You can watch a video of the event via Bloomberg.com here. Also notice how the mainstream media’s coverage of this event emphasizes a short-term view, with Bloomberg’s headline focusing on Bernanke’s political speech, rather than the very interesting Long Bottom Line style questions that the speakers answered later in the same event.